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How are mutual fund managers compensated?

A mutual fund announces that the salaries of its fund managers will depend on the performance of the fund. If the fund loses money, the salaries will be zero. If the fund makes a profit, the salaries will be proportional to the profit. Describe the salary of a fund manager as an option. How is a fund manager motivated to behave with this type of remuneration package?

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The salary of a fund manager can be couched in terms of an option contract requiring performance before payment.

An option contract is defined as "a promise which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer." Restatement (Second) of Contracts ยง 87 (1981).http://en.wikipedia.org/wiki/Option_contract

The option contract ...

Solution Summary

The solution discusses the possible results of several methods of compensating mutual fund managers.